Over the last month, it's been hard to miss talk in the media and on social channels about initial coin offerings, or ICOs. What are they? Where did they suddenly come from? Who's investing in them?
When the popular investing platform AngelList announced on Monday that it's jumping into the business of making ICOs easier to coordinate, attention reached a fever pitch, prompting my colleague Alex Wilhelm to yesterday tackle the question, "WTF is an ICO?"
Because this editor was still confused (I'm not proud), I talked yesterday with Stan Miroshnik, a UC Berkeley grad with an MBA from MIT who today runs L.A.-based Argon Group, one of the first digital finance-focused investment banks. Miroshnik nicely answered an array of questions about ICOs, including how these things get staged, how companies establish a value for their offerings, and more. If you're still trying to get a handle of this latest investing trend, too, read on.
TC: ICOs are everywhere suddenly. When was the first ICO staged?
SM: You have to go back to around 2013, when Mastercoin, a protocol on top the bitcoin blockchain, raised $500,000. Then you had a number of other milestone token sales, such as Ethereum in 2014, then the DAO, or Decentralized Autonomous Organization, which was built on the Ethereum blockchain and that stored and transmitted Ether and Ethereum-based assets and that raised the equivalent of $150 million last year.
Momentum began to build after that, as a smaller group of [these offerings] grew in size, and by last fall, some companies were raising millions of dollars in minutes. That really kind of made people stand up and wonder if this is a new funding mechanism.
TC: How many ICOs have there been to date?
SM: There were 64 last year that collectively raised $103 million, excluding the DAO. So far this year, we've seen 25 offerings raise a bit more than $163 million, and we're on track to see more than $210 million raised by the end of June.
TC: The idea is that instead of raise traditional funding from a bank or investors, a company that sells tokens to its customers ensures those customers are better aligned with the company's success. Is that accurate?
SM: Yes. If I’m buying your token, I am incentivized to help the company's product and ecosystem expand, bring in other users, maximize the tokens' utility, and I’m hoping that demand for the token will increase and it may become more valuable. You're creating the network and virality effect with these monetary incentives.
The term ICO is really a misnomer for what are token sales or token crowd sales.
TC: So how do these ICOs work, practically speaking?
SM: There’s a cadence to these things. You do the prep-work and get your project to a natural technical milestone. Then you pre-announce when you’re planning to have a token sale, describing some of the terms, and telling a story of the project and its goals. You publish a white paper and disclosure and give people a chance to read it and comment. There are also usually threads that develop on Reddit, Bitcointalk, Slack, Telegram and elsewhere, where people actively debate the merits of the product. Then, on the landing page on the aforementioned date, there’s typically a tool that enables purchasers to acquire the tokens in exchange for bitcoin or ether.
TC: These require digital wallets?
SM: [The issuing company] requests [the investor's] source wallet and the wallet where the token buyer wants to receive the token. Once the company collects the money, the sale is concluded, the smart contract is deployed, the tokens are issues via the smart contract, and delivered to the token purchasers.
TC: How do companies establish a value for the tokens they’re offering?
SM: Typically, a company sets out of a goal, then in the sales process, they can either discover what the market is willing to pay, as with a Dutch auction, or they can stipulate the price themselves and explain what the use of the proceeds will be. The value of the token lies in its functionality and utility.
Token holders are effectively prepaying for a product or service. If I run a video game company, for example, I can sell you tokens that represent in-game purchases once the game is built. If you know you’ll buy swords and shields and things like that, you can just pay for them now. It helps me develop the game and gives me more capital to do it, and you benefit from the currency becoming more valuable over time, because there’s a finite amount of it issued. The currency will presumably appreciate because the game will become more popular, and you were going to participate in it anyway, but now you’re also supporting the game developers.
TC: Do people always buy these tokens with cryptocurrencies?
SM: For the most part, they do. Sometimes, token sales involve dollars or other fiat currencies.
TC: Does it matter?
SM: Companies mostly use cryptocurrencies out of an abundance of caution. When you’re using fiat currency, you start touching the margins of banking and money transmitter regulations, and using cryptocurrencies keeps you clear of them. It’s also the case that a lot of your audience – right now, at least – is part of the cryptocurrency world anyway. These are people who have [digital] wallets. It’s not hard for them.
TC: Is there a concern that U.S. regulators will crack down on these ICOs?
SM: Lawyers are relying on case law that defines what a security is. The most well-known case is the "Howey Test,” created by the Supreme Court for determining whether certain transactions qualify as investment contracts. If they do, then those transactions are considered securities and are subject to certain disclosure and registration requirements. When tokens are structured basically as the sale of a service or product, they’re designed to make sure the various prongs of the test are not triggered.
TC: So the SEC hasn't reached out to anyone about these.
SM: The SEC and other regulators are engaged and aware of the developments in this market, but they're taking a measured approach. It hasn't taken a view publicly, put out a paper, or taken an enforcement action in the space. Other regulators such as the CFTC, the OCC, and state-level bodies are watching carefully.
TC: Where are most ICOs staged?
SM: It’s really a global industry. Some are in the U.S. and structured through Delaware [where many companies are incorporated]. Some are structured in Switzerland, some in Singapore, which has a very token-friendly regime where tokens aren’t considered a security. Companies are coming from many countries.
TC: What types of companies are primarily using ICOs?
SM: It's still a financing mechanism that's very organic to the blockchain community.
It all started with protocols like Ethereum raising funding through this mechanism, and it has stayed close to related projects, like the distributed storage company Storj and Civic, a company that provides identify through the blockchain and is announcing its token sale this Thursday. A lot of these founders and token buyers are part of bitcoin forums and Reddit, and that’s why [certain companies] are able to raise these large sums fairly quickly; they’re reaching out to thought leaders and getting their support and generating buzz about their projects. It’s basically the open source community, now with an open-source funding mechanism.
TC: For how much longer, do you think? ICOs are getting tons of attention suddenly, as you know.
SM: We’re definitely starting to see more and more companies that are outside this core space beginning to examine [this new financing mechanism]. But it’s early days.
TC: What happens when people want to sell the tokens they’ve bought?
SM: Well, first, you can use them in a company’s ecosystem. With Storj, maybe you buy storage. You can also accumulate these tokens over time, as a bet that with more enterprise demand for storage capacity, the coins will become more valuable, after which you can sell your tokens to someone else who needs to purchase storage space.
TC: Is there any kind of lock-up period, or can a token holder immediately sell that token if he or she wants?
SM: There hasn’t been a lock-up period traditionally, but over the last two months, a practice has started to develop [toward that end] as transactions are getting larger, because it clearly makes a lot of sense. In the case of Storj, some purchasers that committed early received discounts but were also locked up [from selling] for between 3 and 12 months. So I think we’re beginning to see the maturation of market [in a way that reflects] traditional dynamics.
TC: Should VCs be nervous about ICOs? You mention Civic, which is staging an ICO. Civic has also raised some venture capital previously. But plenty of other companies seem to be skipping the VC part.
SM: To some degree they should, but we’ve also talked with a lot of very smart VCs who are looking at this space, including August Capital, Tim and Adam Draper, Blockchain Capital. Many are doing the work to understand how to be involved and active in the space and the fundamental value of these protocols. Union Square Ventures has said it now has a mandate from its LPs to hold these assets.
For companies that raise funds through a token sale and that have had traditional angel or venture rounds previously, for example, their equity investors get to skip one or two rounds of dilution, which is great; it means their returns are hyper-levered.
TC: Is there a bubble forming?
SM: There is a lot of velocity, but it’s coming from the liquidity that’s coming into this industry. A lot of early bitcoin investors are [plugging some of their rewards from its run-up in price] into these projects where the team is technically strong and the product or protocol is robust and addressing a large or hard problem.
More, every day I talk with hedge fund managers who just stumbled across this space and recognize that a diversified portfolio that includes a non-correlated asset like bitcoin has been shown to raise their sharp ratio, so we’re starting to see more adventurous family offices and high-net-worth individuals participate in these token sales.
TC: These offerings largely center on projects and not fully formed products, if I'm understanding correctly. That makes some outsiders nervous. Do you worry about bad actors?
SM: It's really early. This whole market is just a couple of years old. Many projects have been out for less than a year, so it’s too soon to tell. But this is a small community where people know each other, so there’s a lot of founder pride and reputations are at stake. Also, the companies post their white papers publicly, their code is up on Github, and their token smart contracts are often peer audited, so [potential buyers] have some transparency in terms of where a product is in its cycle and also the community's level of buy-in.
As with everything, it’s buyer beware. You certainly shouldn’t be buying token in projects you don’t understand.